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This dissertation is a study of deviations from covered interest rate parity (CIP) as imperfections in dollar funding markets and their macroeconomic implications. It explores how CIP deviations relate to key policy tools, monetary policy and central bank swap lines, which play a crucial role in supporting the international monetary and financial system. In particular, I analyze how CIP deviations affect the transmission of US monetary policy and determine the optimal central bank swap line policy for stabilizing CIP deviations.
In the first chapter, I empirically examine effects of US monetary policy on CIP deviations in the post-global financial crisis (GFC) period. For this purpose, I construct a panel dataset consisting of CIP deviations for G10 currencies and US monetary policy shocks identified using the high-frequency method. Currency fixed effect regressions reveal that a contractionary US monetary policy shock significantly widens CIP deviations in the post-GFC period. This suggests that the cost of synthetic dollar funding increases more than direct dollar funding, given that synthetic funding has generally been more expensive since the GFC. Furthermore, impulse response analysis, estimated using local projections with high-frequency monetary surprises as instrumental variables, shows that these effects are persistent over time.
The second chapter proposes a new transmission channel of US monetary policy through FX swap markets: the synthetic dollar funding channel. To explain this, I develop a two-country New Keynesian model with an FX swap market, where US banks supply synthetic dollar funding by arbitraging CIP deviations while non-US banks demand it for currency matching. CIP deviations arise since US banks face limits on arbitrage. The calibrated model shows that a contractionary US monetary policy shock widens CIP deviations by tightening these limits on arbitrage and increasing the shadow cost of balance sheet space. Compared to a counterfactual scenario where CIP holds, macroeconomic spillovers and spillbacks are amplified because the widening of CIP deviations functions as a financial accelerator. Finally, I show that central bank swap lines attenuate the synthetic dollar funding channel.
The final chapter studies the optimal central bank swap line policy. Due to a pecuniary externality, there is a trade-off between ex-ante and ex-post efficiency of the swap line policy. During financial crises, the swap line policy lowers CIP deviations and prevents fire sale of source currency assets, beneficial to both recipient and source country. However, it makes recipient banks to overborrow ex-ante, sowing the seeds of financial crises. From a global welfare point of view, the ex-post efficient policy is more lenient than the ex-ante efficient policy, which implies time inconsistency. The policy mix with macroprudential policies can correct the overborrowing problem and resolve time inconsistency. Moreover, policy coordination of a cooperative Ramsey problem obtains undersupply (oversupply) of source currency provision under a realistic condition when the source country has higher (lower) bargaining power.